New York’s SALT Substitute

Anxious to retain one-percenters, Governor Cuomo rehearses some clumsy tax solutions.

by E.J. McMahon |  | City Journal

New York governor Andrew Cuomo began 2018 the way he ended 2017: demonizing Washington Republicans and fulminating against the newly enacted federal tax reform, especially its $10,000 cap on state and local tax (SALT) deductions. Denouncing the tax reform bill as “devastating” and “an economic missile [that] says ‘New York’ on it,” Cuomo announced in his January State of the State message that he’d explore “a major shift” of New York’s state tax burden from individuals (who will be losing income tax deductions) to businesses (which will be keeping them), via a new statewide payroll tax on employers. Two weeks later, Cuomo devoted a portion of his fiscal 2019 budget presentation to the same subject, pledging again to come up with a plan to restructure the code by shifting from an employee-paid to an employer-paid income-tax system. “This shift, while dramatic, would in many ways, thwart what the federal government was trying to do,” he said.

Absent a firm proposal, however, Cuomo’s search for a SALT substitute has been more of a distraction than a serious policy initiative. The governor’s own wildly overblown rhetoric on the issue hasn’t helped. At one point in his budget presentation, for example, he claimed that “everyone in the state of New York gets a tax increase by losing the (SALT) deductibility,” which is flatly wrong. In fact, the majority of New York households will see their federal taxes cut. Even for most itemizers, the SALT cap will be offset by a combination of federal tax-rate cuts, a big expansion of the child credit, curtailment of the Alternative Minimum Tax, and—perhaps most significantly—a near-doubling of the standard deduction. In fact, many fewer New Yorkers will need to itemize under the new law.

What actually has to worry Cuomo is the impact of the SALT cap on the highest-earning 1 percent of New Yorkers, who generate 42 percent of the state personal income tax (PIT) receipts. The Empire State’s income millionaires will lose SALT deductions that averaged $500,000 in 2015, the latest year for which such data are available from the IRS. New York’s dependence on high earners has been reinforced in recent years by Cuomo’s repeated extension of a supposedly temporary PIT surtax on those earning more than $1 million (or $2 million for married joint filers). Roughly half the state residents in that bracket live in New York City, where the net result of the federal tax changes will be an increase in the combined federal, state, and local income-tax rate on the highest earners. Without a federal SALT deduction discount, the state and local tax rate in New York City will stand at its highest level ever. The city’s wealthiest residents will now have an even stronger incentive to minimize their exposure to New York taxes, including moving their primary residence to low-tax states, where many already have second or third homes.

So at first blush, the notion of finding ways to retain full deductibility has obvious appeal. But accomplishing it via a shift to a payroll tax is far easier said than done. For one thing, New York’s income tax is imposed at progressively higher rates based on income, family size, and marital status. But payroll taxes across the country—including the mass-transit tax in the New York City region—are imposed at a flat rate.  Theoretically, a progressive payroll tax could be constructed on the basis of, say, employee W-4 withholding certificates. Lots of other problems and questions would remain, though.

For example, an employer payroll tax would be tantamount to an outright business-tax increase, because the tax itself adds to the cost of employing the worker— unless the amounts now withheld for state income taxes are instead retained by employers. That would require workers to take a corresponding cut in their gross, pre-tax pay. Government and the largely non-profit health-care and higher-education sectors account for roughly one-fifth of the workers and payrolls in New York State. Cuomo describes a payroll tax as a way to force the federal government to continue subsidizing New York taxes—but while businesses can deduct the cost of the state payroll tax from their federal income tax, government and nonprofits don’t pay federal income taxes, and thus would eat the whole cost of the shift.

The new federal corporate rate is just 21 percent, meaning a payroll-tax deduction for “C” corporations would be worth much less than the no-longer-available individual income-tax deduction against the new top rate of 37 percent (previously 40.6 percent). Further, roughly one-third of the adjusted gross income earned by New York residents—and two-thirds of top-bracket earners’ income—consists of capital gains and business-partnership profits that would be untouched by a payroll tax. In other words, an income tax would have to be retained.

Roughly 17 percent of New York State’s income tax receipts come from residents of other states, and roughly two-thirds of that amount originates with workers living in New Jersey and Connecticut. These commuters are now fully credited for New York taxes on their home states’ income-tax returns; if New York shifted to a payroll tax, they’d find themselves at least indirectly double-taxed. A state Department of Taxation and Finance study suggested Cuomo could get around some of these problems by allowing businesses to opt into some new form of corporate organization, or even by creating a statewide version of New York City’s unique (and widely disliked) Unincorporated Business Tax (UBT). The notion of creating some new avenue of taxation—even if, initially, for the benign purpose of preserving deductibility—must be worrisome for New York employers.

Probably the most workable scenario for New York would be find to a tax option affecting only the most high-salaried individuals. They would still be subject to state income tax, but their liability would be matched by a dollar-for-dollar state-tax credit that would match a portion of their liability—the part they can no longer deduct on federal taxes in the top bracket. By focusing on this small, yet fiscally hyper-significant, group of New Yorkers who are losing the most in SALT deductions, this approach would spare the vast majority of employers from the impossible complexities of a broad new parallel tax system.

But a system of matching tax credits “poses potential legal issues,” the Tax Foundation’s Jared Wolczak said in a policy paper. “The IRS might well conclude that this is little more than a shell game, with the employer effectively remitting the employee’s income tax payments on his or her behalf.” A simpler option would create a state-sponsored charitable foundation to receive deductible charitable contributions, in lieu of taxes, to support specific government services such as education. The most obvious model would be Arizona’s array of matching state income-tax credits for federally qualified gifts to charities benefitting the poor, including a major private school scholarship fund.

Residents of New York City pay the second-highest state-and-local taxes in the country—exceeded only by California’s 13.3 percent. But while his budget is even more dependent on millionaire earners than New York’s, California governor Jerry Brown has been more circumspect than Cuomo about the notion of finding federally deductible SALT substitutes. In brief remarks at his own preliminary budget rollout earlier this month, Brown responded to a reporter’s question on a legislative proposal to create a California state foundation that would accept charitable contributions. “I’m certainly open to it, it looks interesting,” Brown said. “But . . . two questions: can it work, and if it does work, can the Internal Revenue Service issue a regulation and completely subvert it?” The Tax Foundation’s Wolczak, among others, has his doubts. “Case law and IRS regulations generally require charitable intent for a contribution to be deductible, meaning that the individual does not receive a substantial benefit from the contribution,” he wrote. “Against this requirement, the sole purpose of the proposed contributions in lieu of taxes . . . is financial gain.”

Cuomo seems determined to plow ahead, apparently hoping to firm up a proposal in time for inclusion in his mid-February budget amendments. Meanwhile, his head-spinning talk of new taxes has served to divert media and public attention from more fundamental problems with his Executive Budget—the most precariously balanced of the eight he has proposed since 2011.

To close a potential $4.4 billion gap between projected spending and revenues, Cuomo proposed $1 billion in “revenue actions” for the coming 2019 fiscal year. Three-quarters would come from the health-care sector, including $140 million from a new tax on supposed “windfall” underwriting gains of for-profit health insurers, and a $127 million “opioid epidemic surcharge” on opioid-based pain medications. Cuomo also claims that the state can count on raking in $750 million per year, or $3 billion over the next four years, from the conversion of nonprofit New York health insurers to for-profit status. Of that amount, he’d deposit $250 million a year, or a total of $1 billion over four years, in a contingency fund to cover possible cuts to federal health-care spending—cuts he was treating as imminent a year ago, during the congressional Obamacare repeal battle, but apparently now hopes won’t happen.

Another $500 million in conversion proceeds annually over the next four years would support Albany’s share of a state Medicaid program that, still dependent on significant federal Obamacare subsidies, is also increasingly burdened by Cuomo’s own multiyear minimum-wage increase. As the Empire Center’s Bill Hammond pointed out, the projected $703 million impact of the wage hike on health-care workers’ salaries next year will be “two-and-a-half times more than projected when the wage hike passed in 2016, and about 20 percent more than projected as recently as November.” By fiscal 2020, Hammond said, “the annual impact will approach $1.2 billion, enough to buy Medicaid coverage for some 400,000 children.”

Back on the tax side, even while harshly attacking congressional Republicans for targeting New York’s SALT deduction, Cuomo failed to initially propose any adjustment for an automatic, federally driven cut in itemized deductions on state income-tax returns. New York, like most states that tax personal income, defines income largely with reference to the federal-tax provisions. Absent any change, New Yorkers will lose $725 million in itemized deductions for the 2018 tax year, including $400 million in property-tax deductions. Despite the obvious inconsistency with the governor’s attack on deduction limits in the new federal law, the out-year revenue projections in Cuomo’s financial plan assume the state will collect at least $700 million in added revenue from curtailing its own local-tax deductions. And it’s not just state itemizers who would be hit. Cuomo’s tax department estimated that, as the law is now written, 5.2 million single filers face a state income-tax hike of $840 million due to some quirky statutory linkage between New York’s standard deduction and federal dependent exemptions, now eliminated.

When Senate Republicans spotlighted the issue by passing a bill that would decouple New York’s income tax law from the new federal provisions, Cuomo issued a statement promising to do the same thing in his budget amendments.

It’s not as if Cuomo’s budget staff was unaware that passage of the federal reforms would necessitate some adjustments in state law. Indeed, the sole conformance provision included in Cuomo’s initial budget legislation is designed to decouple New York’s tax code from a federal change that would otherwise result in a sizable tax cut for New Yorkers: the doubling of the federal child credit. With no change in the law, New Yorkers with kids stood to save $500 million from an increase in the state’s Empire Child Credit.

Cuomo has sought to dramatize the response to federal tax and budget changes as “the fight of New York’s future.” So far, however, he’s hobbled by an insistence on preserving as much as possible of New York’s heavy-spending past.